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Finance leases

Finance leases are a method of financing, typically employed where the lessee wishes to acquire the rights of use and economic benefits of a specific asset over the greater part of its useful life. Importantly, a substantial proportion of the risks relating to ownership is borne by the lessee, even though title to the asset remains with the lessor.

The initial recognition of a finance lease under FRS 102 section 20¹ is at the lower of the fair value of the leased asset or the present value of the minimum lease payments, calculated using the interest rate implicit in the lease. Lease payments are then spread over the term of the lease using an effective interest method. For the purposes of transfer pricing, these transactions should be treated similarly to secured loans. The arm's length principle suggests that there should be a profit element attributable to the lease payments for the lessor. In order to achieve this, the rate of interest in the lease should reflect an appropriate rate of return for the lessor.